Description

Company Description

 Loral Space & Communications (LORL US) is a satellite communications company. The current LORL US was formed in Jun-2005 as the restructured entity that succeeded the Old Loral which emerged from Chapter 11 in Nov-05. LORL US operates two businesses: Satellite Manufacturing and Satellite Services. Through its wholly-owned subsidiary, Space Systems/Loral (SS/L), LORL US designs and manufactures satellites. LORL US also participates in satellite services operations through its 64% ownership stake (33.3% voting interest) in Telesat. Telesat is the fourth largest FSS operator globally, after SES Global, Intelsat and Eutelsat. As of June-2009, Telesat operated 11 in-orbit satellites. LORL obtained its interest in Telesat when PSP (Canadian pension fund) did a LBO of Telesat from Bell Canada, and LORL subsequently merged its Skynet FSS business into Telesat. Due to restrictions imposed by Canadian foreign ownership rules, LORL can only own 33% of the voting interest of Telesat. Accordingly, it uses the equity method to account for its investment in Telesat.

 Investment Thesis

 LORL is a compelling sum-of-the-parts story. At the current share price, and net of the $104m of net cash on LORL's balance sheet, we think that the market is attributing to LORL's share price a fraction of the value of LORL's 64% stake in Telesat. Based on conservative valuation multiples for LORL's SS/L business and comparative trading multiples for Telesat, our base case scenario target price for LORL is $57.2 per share, or 147% upside from the current share price.

 Description of Businesses

 SS/L

 SS/L is one of the largest and most sophisticated builders of commercial satellites globally. Global competitors include the likes of Lockheed Martin, Boeing (who mostly build government satellites these days), EADS, and Thales. Out of the 13 mid/large satellite awards in 2008, 7 orders went to LORL.

 The demand for commercial satellites is driven both by a replacement cycle and incremental market growth. The biggest FSS fleet of the world is entering a major replacement cycle. We estimate that Intelsat, the largest FSS operator in the world, has an average fleet age of slightly more than 10 years. With the average satellite having a life span of 15 years, Intelsat will be embarking on a significant replacement cycle to bring its fleet age down. At the same time, HD penetration and the launch of new Pay TV platforms, especially in emerging markets, is driving significant demand growth for commercial satellites. Companies such as SES Global and Eutelsat are adding significant capacity to take advantage of this increasing demand. The satellite operators have an aggressive launch schedule over the next 3 years.

 SS/L generated revenues of $881m in FY08, and EBITDA of $45m. So far in FY09, SS/L has generated revenue of $492m and EBITDA of $23m. However, funded backlog has climbed from $1.24bn at 31-Dec-08 (or 1.4x FY08 revenues), to $1.76bn at 30-Jun-09 (or 1.8x annualized H1 FY09 revenues). For a manufacturing business, SS/L's ability to grow its funded backlog in the current business environment is testimony to the strength of the secular forces mentioned above.

 While LORL's EBITDA margins are around 5%, we think the competitors have EBITDA margins that are close to 10% of revenues. We are modeling for $1bn of revenues in both FY09 and FY10 and 5% EBITDA margins in FY09 and 5.5% in FY10 respectively to arrive at $50m and $55m of EBITDA in FY09 and FY10 respectively. Every $5m of EBITDA movement (at 6x multiple) is worth $1.0 to LORL. We think that management can improve margins due to operational leverage as topline grows, but as a general matter, do not think our thesis on LORL is much impacted by the SS/L operations. The bulk of the value is through LORL's ownership of Telesat.

 Telesat

 Despite LORL's modest valuation based solely on its SS/L business, our LORL's share price valuation targets are predicated on the fact that LORL's biggest asset, its 64% stake in Telesat, is off balance sheet and is neither recognized nor properly valued by investors. Telesat is not consolidated in LORL's financial reporting and is only equity accounted and therefore represents "hidden" value.

 Attractive Industry Characteristics of the FSS Industry and Telesat 

•1.       Substantial barriers to entry

• a. The FSS industry is characterized by in-perpetuity rights to orbital slots, significant amounts of technical know-how, substantial to meet up-front investment costs, with increasing economies of to scale.
• b. These factors limit the threat of new entrants and limitless supply expansion.  

•2.       Stable oligopoly with high profit margins and strong recurring cash flow

• a. Given the high capital intensity of the FSS industry (satellites cost between $200m to $250m each to launch), the industry has become an oligopolistic structure. Four operators (SESG FP, Intelsat, ETL FP and Telesat) account for more than 70% of worldwide market share by transponders.
• b. As expected, the industry structure gives rise to high profitability characterized by EBITDA margins for the major operators of between 70% and 80% and strong, recurring cash flows.
• c. There has been significant consolidation in the sector in the past few years - notably Loral Skynet / Telesat, PanAmSat / Intelsat, and SES Global / New Skies. This consolidated market structure has fostered increasing pricing stability, more rational business practices and discipline.  

•3.       Attractive top line visibility / stability of cash flows

• a. So far into this economic downturn, FSS operators have shown the ability to grow through the cycle while sustaining very resilient cash flow generation due to the mission-critical nature of FSS's product offerings.
• b. FSS operators tend to have very long order books. Revenue visibility is underlined by the 'backlog' value of current contracts with FSS operators having backlogs of between 3.5x to 6.5x annual revenues. 

•4.       Secular growth drivers due to channel growth in emerging markets and the proliferation of HD TV in the developed world

• a. New pay TV platforms are being developed in emerging markets (Africa, Middle East, Eastern Europe and emerging Asia).
• b. In the developed world, the driver for increased transponder demand comes from the proliferation of HD TV (which uses more bandwidth than standard definition. HD TV channels are growing with increasing adoption of HD compatible TV.
• c. From the pay-TV operator's perspective, HDTV is seen as a differentiating product versus terrestrial broadcasters.

Telesat is well positioned for growth 

With regards to Telesat, Canada has the advantage of having orbital slots that can be used to beam into the United States. A senior executive at one of the two publicly-listed operators told us that Teleast has a de-facto monopoly position in Canada. 

Globally, only SES Global and Eutelsat are publicly traded. Both Intelsat and Telesat are currently private with LBO structures. In terms of trading valuations, SES Global and Eutelsat trade between 7.7x and 9.3x FY09 EBITDA. While Telesat EBITDA margins are lower than its comparables due to the relatively smaller fleet size, the company has expanded margins from 60% to 70% in the last year due to operational leverage and Skynet / Telesat cost synergies. 

 Telesat currently operates 11 in-orbit satellites, with an additional satellite (Nimiq 5) to be launched on 18-Sep-09. Nimiq 5 is fully contracted to Bell TV for 15 years from launch (of which half of the capacity is subleased to Echostar and DirectTV). We expect Nimiq 5 to lead to 160bps of margin expansion.   

 The FSS operating run rate is a good barometer for the future (due to non-existent churn and very long contract terms of between 5 years and 15 years). For the quarter ending 30-Jun-09, Telesat generated CAD201m in revenue and CAD143m in EBITDA (or CAD800m of annual revenue and CAD570m of annual EBITDA). We estimate that Nimiq 5 will generate CAD68m of annual revenue, and CAD58m of annual EBITDA, when launched. We thus estimate that Telesat will have a run rate revenue of CAD870m and EBITDA of CAD630m in FY10 post the launch of Nimiq 5. 

Compelling Valuation 

 For our downside case    

• 1. Based on comparable EBITDA multiples, we value Telesat at 7x (10% below the lowest valuation in the group) the post Nimiq 5 run rate EBITDA, and estimate that LORL's equity stake in Telesat is worth $26.6 per LORL share.
• 2. We also value SS/L value to LORL at $7.7 per LORL share ($45m at 5.0x EBITDA)
• 3. LORL has net cash of $3.5 per LORL share.
• 4. LORL also has central costs that we value at -$3.40 per LORL share.
• 5. Our downside valuation of LORL suggests a target price of $34.4 per share, suggesting upside potential of 49% even in our downside scenario.                                                  

For our base case 

• 1. Based on comparable EBITDA multiples, we value Telesat at 8.5x (average of group) the post Nimiq 5 run rate EBITDA, and estimate that LORL's equity stake in Telesat is worth $45.8 per LORL share.
• 2. We also value SS/L value to LORL at $11.3 per LORL share ($55m at 6.0x EBITDA).
• 3. LORL has net cash of $3.5 per LORL share.
• 4. LORL also has central costs that we value at -$3.40 per LORL share.
• 5. Our base valuation of LORL suggests a target price of $57.2 per share, suggesting upside potential in our base case scenario of 147%. 

For our upside case 

• 1. Based on comparable EBITDA multiples, we value Telesat at 9x (near the high end multiple of the group) the post Nimiq 5 run rate EBITDA, and estimate that LORL's equity stake in Telesat is worth $63.1 per LORL share. Here, we also assume that LORL can increase utilization by 10% from the current 83% to 91%.
• 2. We also value SS/L value to LORL at $16.8 per LORL share ($70m at 7.0x EBITDA).
• 3. LORL has net cash of $3.5 per LORL share.
• 4. LORL also has central costs that we value at -$3.40 per LORL share.
• 5. Our upside valuation of LORL suggests a target price of $80.0 per share, suggesting upside potential on an upside case of 246%.      

Unlocking Value

While hard to pin down what the catalyst to unlock the value at LORL is, we think that the underlying value at LORL is very compelling. We think that there are two potential transactions that could happen for the value to be unlocked:

 Reverse takeout of LORL by Telesat--Due to Canadian ownership laws, it is not possible for LORL to have control over Telesat.  However, we see no reason why Telesat cannot do a reverse deal and take out LORL instead.

 Takeover of LORL's stake in Telesat and LORL to sell the SS/L business--From our understanding, LORL had conversations with both Boeing and Lockheed Martin to combine their satellite manufacturing businesses. We note here that public transaction comps for FSS businesses have taken place at between 10x and 12x EBITDA. At 10x a run-rate EBITDA of 690m (as per our upside scenario), LORL's stake in Telesat is worth $77.1 per LORL share (as opposed to the $63.1 per LORL share in the upside scenario), and LORL will be worth $94.0 per share, or a 307% upside from the current share price.

Catalyst